Fixed and Floating Exchange rate system

Fixed and floating exchange rate systems are two different ways in which countries can manage their exchange rates.

Fixed Exchange Rate System: In a fixed exchange rate system, the exchange rate of a country’s currency is fixed to another currency, usually the US dollar or a basket of currencies. This means that the central bank of the country must maintain the exchange rate by buying or selling its currency in the foreign exchange market. For example, if the exchange rate is fixed at 1 US dollar = 10 units of the domestic currency, then the central bank must sell domestic currency and buy US dollars if the exchange rate rises above this level, and buy domestic currency and sell US dollars if the exchange rate falls below this level.

Advantages of Fixed Exchange Rate System:

It can provide stability and predictability in international trade and investment.

It can reduce uncertainty for businesses and investors.

It can help control inflation by limiting the amount of domestic currency in circulation.

Disadvantages of Fixed Exchange Rate System:

It can be difficult to maintain the exchange rate if there are changes in the global economy.

It may limit a country’s ability to pursue independent monetary policy.

It can lead to currency shortages or surpluses.

Floating Exchange Rate System: In a floating exchange rate system, the exchange rate of a country’s currency is determined by supply and demand in the foreign exchange market. The central bank does not intervene to maintain the exchange rate, and it allows the exchange rate to fluctuate freely. The value of the currency can rise or fall based on market forces such as interest rates, inflation, and economic growth.

Advantages of Floating Exchange Rate System:

It can adjust to changes in the global economy without the need for central bank intervention.

It can allow a country to pursue independent monetary policy.

It can promote market efficiency by allowing the exchange rate to reflect market conditions.

Disadvantages of Floating Exchange Rate System:

It can be volatile and unpredictable, leading to uncertainty for businesses and investors.

It can make international trade and investment more difficult to plan and execute.

It may not be effective in controlling inflation.

In summary, the choice of exchange rate system depends on a country’s economic goals and circumstances. Fixed exchange rate systems provide stability and predictability, but can be difficult to maintain. Floating exchange rate systems are more flexible, but can be volatile and unpredictable.

Exchange rate system prior to IMF: Gold currency standard, Gold bullion Standard, Gold Exchange Standard

Before the International Monetary Fund (IMF) was established in 1944, several exchange rate systems were used by countries around the world. These systems were all based on the use of gold as a medium of exchange or as a standard against which currencies were valued. The three main exchange rate systems before the IMF were:

Gold Currency Standard: Under the gold currency standard, a country’s currency was directly convertible into gold at a fixed exchange rate. This meant that the currency’s value was backed by a corresponding amount of gold held by the central bank. This system was used by many countries in the 19th century, including the United Kingdom, which adopted the gold standard in 1821.

Gold Bullion Standard: Under the gold bullion standard, a country’s currency was not directly convertible into gold, but gold bullion could be bought and sold in the foreign exchange market. This system was used by many countries in the early 20th century, including the United States, which adopted the gold bullion standard in 1900.

Gold Exchange Standard: Under the gold exchange standard, a country’s currency was not directly convertible into gold, but it could be exchanged for the currency of another country that was convertible into gold. This allowed countries to hold their reserves in the form of foreign currencies that were backed by gold. This system was used by many countries in the interwar period, including France, which adopted the gold exchange standard in 1928.

All of these exchange rate systems were based on the use of gold as a standard of value. However, they were also subject to various economic and political challenges, such as changes in the supply and demand for gold, fluctuations in international trade, and political instability. These challenges ultimately led to the creation of the IMF and the adoption of the Bretton Woods system, which established a new framework for international monetary cooperation and exchange rate stability.

Exchange rate system under IMF: Bretton woods system, The Smithsonian Agreement , The flexible Exchange Rate Regime

The International Monetary Fund (IMF) was established in 1944 with the goal of promoting international monetary cooperation and exchange rate stability. The IMF has overseen several exchange rate systems since its inception, including:

Bretton Woods System: The Bretton Woods system was established in 1944 and was the first exchange rate system created under the IMF. Under this system, the US dollar was fixed to gold at a rate of $35 per ounce, and other currencies were fixed to the US dollar. This meant that the exchange rates between currencies were fixed, with only minor fluctuations allowed. The Bretton Woods system was used until 1971, when the US suspended the convertibility of the US dollar into gold, leading to the collapse of the system.

The Smithsonian Agreement: The Smithsonian Agreement was established in 1971 as a response to the collapse of the Bretton Woods system. Under this system, the US dollar was devalued and other major currencies were revalued, leading to a realignment of exchange rates. This system was short-lived, however, as the exchange rates between currencies continued to fluctuate.

The Flexible Exchange Rate Regime: The flexible exchange rate regime, also known as the floating exchange rate system, was established in the 1970s and is the current exchange rate system used by most countries. Under this system, exchange rates are determined by supply and demand in the foreign exchange market, and there is no fixed exchange rate or gold standard. Central banks may intervene in the foreign exchange market to influence exchange rates, but this is not a requirement under the flexible exchange rate regime.

Overall, the IMF has played a key role in shaping international exchange rate systems, and its efforts have contributed to greater stability and predictability in international trade and investment. The flexible exchange rate regime has allowed countries to pursue independent monetary policy and adjust to changes in the global economy, but it has also led to increased volatility and uncertainty in exchange rates.